Inflation or Deflation?

The following interview, conducted by Louis James, a senior analyst
and editor with Casey Research, appeared in the March 08' edition of Casey's International
Speculator.

Louis James (LJ): The first question we think most readers will want
to know about is this: if the U.S. is headed for recession - if not already
sliding into one - do you really think we're facing more inflation in the near
future, or could falling spending power cause deflation?

Bud Conrad (BC): There are strong deflationary pressures in a credit
collapse because as housing prices drop and defaults rise, some of the ability
to buy new items is lost. Traditional analysis suggests that we could have
deflation such as that which occurred in the Great Depression in the U.S. in
the late 1920s, early 1930s. I would point out, however, that in the Great
Depression the dollar was linked to gold, limiting the amount of money printing
that could be done, a limitation that does not exist today. In addition, with
$100 oil it is hard to argue for deflation. My base prediction is that we are
heading into an inflationary period.

LJ: If there was any doubt about inflation vs. deflation, has it been
settled by the central banks of the world as they responded to last summer's
credit crunch with greater liquidity?

BC: Yes. That is the point. The governments and their central banks
have no limit on how much money they can create since there is no tie to gold
or anything else. It is only logical to expect them to take the easy road and
print money. The result is predictable. New government bailouts for whatever
problems arise are going to continue.

LJ: With war spending, ballooning entitlements, a crisis of confidence
in the U.S. financial system stewing, along with many other woes, do you think
there's any chance that the U.S. will not try to inflate its way out of its
current economic predicaments?

BC: In a word, no. Inflating its way out of problems has become the
default solution for the U.S. government, and governments around the world.
Consider, the price tag for the wars in Iraq and Afghanistan is now credibly
estimated at $3 trillion. The economic stimulus package passed by the U.S.
Congress will cost $150 billion, which will come on top of slowing tax receipts
due to the recession, confirming that the U.S. budget deficit will jump to
$400 to $500 billion this year.

That kind of deficit will put yet more pressure on the dollar due to the expectation
that the government will inflate the dollars to pay for the deficits, as well
as further bailouts that may be required as the credit crisis continues to
unfold. And just over the horizon, it gets worse because of the unsustainable
costs of the entitlements due to the 76 million baby boomers now beginning
to look to retirement, and for their government medical payments.

As governments don't actually produce anything, paying for all of this will
have to come either in the form of direct taxation, which has well-established
limitations past which it becomes counter-productive, or from indirect taxation,
in the form of a steady erosion in the value of the dollars that will be used
to meet the government's many obligations. In other words, inflation.

LJ: There's a view among many observers that U.S. trading partners
will have to devalue/inflate their own currencies, or their own economies will
be slammed by a loss of competitiveness of their products in U.S. markets.
This could spill over to those countries that supply raw materials or labor
to the first tier of dominos. Do you think such a "race to the bottom" is likely?
Our survey finds almost universal inflation around the world, and it seems
to be accelerating in most places. Is the race happening already?

BC: Again, yes. The Asian exporters want to expand trade to keep their
workers employed, and are trying to accomplish that goal by supporting the
dollar with unwise, outsized investments in dollar-denominated investments
like Treasuries. As a result, our foreign trading partners have accumulated
$6 trillion of such assets, an unprecedented level of holdings.

This circular investment strategy - in which we buy from foreigners and they
reinvest in our government paper - has provided the capital for the U.S. economy
that our domestic saving has not been able to provide. In the process, it has
kept a lid on consumer prices here in the U.S. for over a decade, essentially
exporting inflation offshore, along with our manufacturing. But the net result
is that the U.S. has done the equivalent of selling off about 23% of its tangible
net worth to foreigners, leaving the system at risk of collapsing.

If there is a positive, it is that we have an environment that evokes memories
of the long-standing military strategy of Mutually Assured Destruction, where
no one wants to be the cause of collapse. The Chinese have pegged their renminbi
to the dollar rather than let it rise, and that has fostered inflation that
is over 6%. The Persian Gulf oil states that peg their currencies to the dollar
suffer the weakness of the dollar, causing higher internal inflation.

The world money supply is growing faster than the production of "stuff," resulting
inevitably in less purchasing power for all currencies. How much longer this
is sustainable is hard to say, but the odds increase every day that foreign
holders of dollars will come to believe that the U.S. government is willing
to sacrifice the dollar, and then they will begin to unload dollars in earnest.
There are signs of this happening already, with the Chinese and others using
their considerable dollar reserves to buy up large natural resource deposits,
even shares in U.S. corporations. In other words, tangible items.

LJ: What other factors do you think might mitigate or exacerbate inflation
worldwide? Do you think the overall trend will be for increasing inflation
that will continue for some time, or are there mitigating factors that might
slow it?

BC: The slowing of world economies we expect in the mid-term may somewhat
mitigate inflationary pressures. However, as we also expect governments to
react as they always do when faced with an economic downturn - namely attempting
to stimulate growth through further monetary creation - this will only plant
the seeds of much higher inflation over the next decade.

LJ: Do you think robust economies like China's can handle whatever
inflation is likely ahead without too much trouble - or is this a serious worldwide
storm that's brewing?

BC: The storm is worldwide. China depends on Western countries to buy
its exports and there will be convulsion from overcapacity in an economic slowing.
They are not immune to U.S. slowing. The Shanghai stock market that went from
1,000 to 6,000 has already pulled back to 5,000 with some anticipation of further
slowing. The world is not decoupled; it is even more coupled than ever. But
on an inflationary view, China has strengths, most importantly goods that the
world wants to buy, and that results in a trade surplus.

LJ: Can you think of any countries insulated enough from the spreading
loss of value that it makes their currencies safer places to put cash? Switzerland?

BC: I look to the countries that are rich in natural resources to maintain
an edge because of the commodity boom. Russia is not a safe country from an
investment perspective, but their oil has given them a completely new life.
Canada has benefited greatly from the natural resource boom and should continue
to do so.

LJ: It's clear from the research you've done that the advent of a pure
fiat monetary system in the early 1970's has triggered a significant increase
in monetary inflation, but why hasn't that caused a greater level of price
inflation than we have seen in recent decades?

BC: Well, we have seen it, but most people don't seem to realize it.
The U.S. dollar has lost 81% of its value since 1971. Bad as that is, it would
have been much worse, if not for the Chinese and others buying our treasuries.
That, in effect, funded our deficit spending and exported our inflation to
their shores. Look at the inflation in China: it's headed higher. Their purchasing
our government and corporate debt was like a vendor financing program for the
sale of their exports to us. In effect, they loaned us the money to buy their
goods.

We haven't faced the ominous task of paying off what is equivalent to a maxed-out
credit card; and when we do, it could spell disaster for the dollar. We have
imported Asia's computers, TVs and clothes, produced with their cheap labor,
keeping our price indexes lower. The bubbles of foreign investment capital
went into the pool of financial assets supporting our stock markets and housing
markets, which certainly had big price inflation, but which are not included
in the common price measures of our inflation like our Consumer Price Index.
Just applying the methods used in 1980 for the CPI, before the government adjusted
the statistics, would suggest that the dollar of 1971 is worth about 7 cents
today.

The Chinese and Japanese have actively supported the dollar to maintain their
exports, but should world dollar holders reverse course, a floodgate of even
worse inflation could come from too many foreign holders all wanting to exit
the dollar at the same time. That almost happened in August 2007. They stepped
back from the potential melt-down, but it's still not safely removed from our
future.

The process is on the track for even more price inflation in the future, because
more people will be waking up to the sham of tissue paper money.

LJ: General loss of value among fiat currencies is obviously good for
the price of gold and the kind of investments we have been recommending here
at Casey Research. Do you have any other suggestions for investors who believe
that inflation of major world currencies is "baked in the cake"?

BC: Watch out for agriculture price rises. A situation you might call
Peak Food is developing. We have the lowest supplies of grains ever compared
to usage. The prices of wheat, corn, soybeans and rice are all double from
what they were a year ago. Dangers of energy shortages leading to food shortage
are growing daily and are not widely enough understood. Rising food prices
will be important additional drivers of inflation across the planet this year.

LJ: May we ask what you're doing with the cash in your own portfolio?

BC: I am, not surprisingly, overweight in precious metals.

LJ: Any final comments?

BC: I usually confine my analysis to economic measures, but the world
political situation is extremely important and intertwined with the economic
consequences. As we look at Asian ascendance, and their expanding importance
on the world scene, we should be aware of the dependencies of their claims
on our assets.

Similarly, the competition for resources is likely to continue, and the worries
over peak oil probably have much to do with our presence in the Middle East.
How these unravel is a bigger discussion than we have time for here, but I
urge watching the international landscape almost as much as our own internal
actions, as the outside forces will direct our future as much as the decisions
at home.

***

Bud Conrad, chief economist at Casey Research, is a regular contributor to
the International Speculator, Casey's monthly flagship publication. The International
Speculator focuses on undervalued junior exploration companies in the
gold and precious metals sector that provide the very real possibility to generate
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Louis James' background in physics, economics, and technical writing prepared
him well for his role as senior editor of the International Speculator and
Casey Investment Alert. Like Doug Casey, Louis constantly travels the world,
visiting highly prospective geological targets, grilling management and company
geologists, and interviewing natives in a variety of languages to find out
what they really think (he's fluent in French and Spanish, and speaks a little
German and Russian).

Whether it's days of back-to-back meetings with mining company executives
in Vancouver, pounding on rocks in the Democratic Republic of the Congo, examining
drill core in Argentina, or eating food with names he can't pronounce with
local miners in China, Louis is constantly looking for the next double-your-money
winner.

He evaluates dozens of companies every month, conducts due diligence of only
the best, and then compares notes with Doug in order to bring only those most
likely to provide rapid high returns to our subscribers' attention. Louis also
reads all the press releases, financial statements, and an enormous quantity
of related information to keep track of all of our mineral companies and has
become something of a walking database on same.

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